Capital Structure

Capital Structure Debt versus Equity Advantages of Debt • Interest is tax deductible (lowers the effective cost of debt) • Debt-holders are limited to a fixed return – so stockholders do not have to share profits if the business does exceptionally well • Debt holders do not have voting rights Disadvantages of Debt • Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk) What is the optimal debt-equity ratio? • Need to consider two kinds of risk: – Business risk – Financial risk Business Risk • Standard measure is beta (controlling for financial risk) • Factors: – Demand variability – Sales price variability – Input cost variability – Ability to develop new products – Foreign exchange exposure – Operating leverage (fixed vs variable costs) Financial Risk • The additional risk placed on the common stockholders as a result of the decision to finance with debt Example of Business Risk • Suppose 10 people decide to form a corporation to manufacture disk drives. • If the firm is capitalized only with common stock – and if each person buys 10% -each investor shares equally in business risk Example of Relationship Between Financial and Business Risk • If the same firm is now capitalized with 50% debt and 50% equity – with five people investing in debt and five investing in equity • The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered). Business and Financial Risk • Financial leverage concentrates the firm’s business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk. Financial Risk • Leverage increases shareholder risk • Leverage also increases the return on equity (to compensate for the higher risk) Question? • Is the increase in expected return due to financial leverage sufficient to compensate stockholders for the increase in risk? Modigliani and Miller • YES • Assuming no taxes, the increase in return to shock-holders resulting from the use of leverage is exactly offset by the increase in risk – hence no benefit to using financial leverage (and no cost). Topics To Be Covered • Leverage in a Tax Free Environment • How Leverage Affects Returns • The Traditional Position Capital Structure • When a firm issues debt and equity securities it splits cash flows into two streams: – Safe stream to bondholders – Risky stream to stockholders Capital Structure • Modigliani and Miller (1958) show that financing decisions don’t matter in perfect capital markets • M&M Proposition 1: – Firms cannot change the total value of their securities by splitting cash flows into two different streams – Firm value is determined by real assets – Capital structure is irrelevant M&M (Debt Policy Doesn’t Matter) • Modigliani & Miller – When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. M&M (Debt Policy Doesn’t Matter) Assumptions • By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: – Investors do not need choice, OR – There are sufficient alternative securities • Capital structure does not affect cash flows e.g... – No taxes – No bankruptcy costs – No effect on management incentives An Example of the Effects of Leverage • D and E are market values of debt and equity of Wapshot Marketing Company. Wapshot has issued 1000 shares and these are currently selling at $50 a share. Wapshot has borrowed $25,000 so Wapshot’s stock is “levered equity”. • E = 1000 x $50 = $50,000 • D= $25,000 • V = E + D = $75,000 Effects of Leverage • What happens if WPS “levers up” again by borrowing an additional $10,000 and at the same time paying out a special dividend of $10 per share, thereby substituting debt for equity? • This should have no impact on WPS assets or total cash flows: – V is unchanged – D= $35,000 – E= $75,000 - $35,000 = $40,000 • Stockholders will suffer a $10,000 capital loss which is exactly offset by the $10,000 special dividend. Effects of Leverage • What if instead of assuming V is unchanged we allow V it rise to $80,000 as a result of the change in capital structure? • Then E = $80,000 - $35,000 = $45,000 • Any increase or decrease in V as a result of the change in capital structure accrues to the shareholders Effects of Leverage • What if the new borrowing increases the risk of bankruptcy? • This would suggest that the risk of the “old debt” is higher (and the value of the old debt is lower) • If this is the case, then shareholders would gain from the increase in leverage at the expense of the original bondholders. Modigliani and Miller • Any combination of securities is as good as any other. • Example: – Two Firms with the same operating income who differ only in capital structure • Firm U is unlevered: VU=EU • Firm L is levered: EL= VL-DL Modigliani and Miller • Four Strategies • Strategy 1 – Buy 1% of Firm U’s Equity • Dollar investment = • Dollar Return= .01VU .01 Profits • Strategy 2 – Buy 1% of Firm L’s Equity and Debt • • • • • Dollar investment= Dollar Return= From owning .01 DL From owning .01 EL Total .01DL + .01EL = .01VL .01 interest .01 (Profits – interest) .01 Profits • Both Strategies give the same payoff Modigliani and Miller • Strategy 3 – Buy 1% of Firm L’s Equity • Dollar investment = • Dollar Return= .01EL= .01(VL-DL) .01 (Profits – interest) • Strategy 4 – Buy 1% of Firm U’s Equity and borrow on your own account .01DL (home-made leverage) • • • • • Dollar investment= Dollar Return= From borrowing .01DL From owning .01 EU Total .01(Vu – DL) -.01 interest .01 (Profits) .01 (Profits – interest) • Both Strategies give the same payoff Modigliani and Miller • It does not matter what risk preferences are for investors. • Just need that investors have the ability to borrow and lend for their own account (and at the same rate as firms) so that they can “undo” any changes in firm’s capital structure • M&M Proposition 1: the value of a firm is independent of its capital structure. Leverage and Returns expected operating income Expected return on assets  ra  market value of all securities  D   E  rA    rD     rE  DE  DE  r M&M Proposition II rE rA rD Risk free debt Risky debt D E M&M Proposition 2 • Bonds are almost risk-free at low debt levels – rD is independent of leverage – rE increases linearly with debt-equity ratios and the increase in expected return reflects increased risk • As firms borrow more, the risk of default rises – rD starts to increase – rE increases more slowly (because the holders of risky debt bear some of the firm’s business risk) The Return on Equity • The increase in expected equity return reflects increased risk • The increase in leverage increases the amplitude of variation in cash flows available to share-holders (the same change in operating income is now distributed among fewer shares) • We can understand the increase in risk in terms of Betas Leverage and Returns  D   E  BA    BD     BE  DE  DE  D BE  BA  BA  BD  E The Traditional Position • What did financial experts think before M&M? • They used the concept of WACC (weighted average cost of capital) – WACC is the expected return on the portfolio of all the company’s securities WACC  WACC is the traditional view of capital structure, risk and return. D  E  WACC  rA    rD     rE  V  V  WACC Expected Return .20=rE Equity All assets .15=rA .10=rD Debt Risk BD BA BE WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million D  E  WACC    rD     rE  V  V  2  3     .08     .15 5  5   .122 or 12.2% The Traditional Position • The return on equity (rE) is constant • WACC declines with increasing leverage because rD